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Group of Thirty: The 2008 Financial Crisis and Its Aftermath

I took the opportunity to read the Group of Thirty’s Opinion Paper on the 2008 Financial Crisis and discovered some interesting points:

Even as late as 2011, when this piece was written, many experts were still mistaken on their assessment regarding the GSEs profitability (or at least so stated)

The piece states several times that Fannie and Freddie were “nationalized” and that was even before the 3rd Amendment / Sweep Agreement enacted in August 2012

The Federal Reserve was culpable for keeping rates too low for too long and for not regulating financial institutions properly

At stake is the 30 year home loan/mortgage that would see higher interest rates paid to banks and less home ownership (less opportunity for lower socioeconomic individuals to build wealth, thus perpetuating continued reliance on government assistance)

And perhaps the most interesting passage in the paper states:

“Moreover …the identities of its largest investors mean that the implications of addressing Fannie and Freddie are not simply limited to its effect on U.S. housing finance. …“a mishandling of the problem…could face scarcer financing, but also investors the world over, including the Chinese, Japanese and other governments and central banks, because foreign investors own about one-third of Fannie’s and Freddie’s noncallable notes.” In fact, some market observers believe this dynamic explains the unconventional 2008 “conservatorship” of Fannie and Freddie, in which existing creditors were made whole regardless of the GSEs’ insolvency: “The political importance of these institutions created a new world, one in which a bond’s performance is determined by the reputation of its holders.… Russia and China were among the largest holders of Fannie and Freddie bonds [in 2008.] …the U.S. was utterly dependent on China to purchase its debt. So, unusually, the identity of the holders, not the condition of the issuer, determined the bond’s fate.”

The conclusion I reach after reading this analysis is that the GSEs were not the cause of the financial crisis, serious miscalculations were made regarding the GSEs’ solvency/profitability and that the main rational for their “nationalization” could likely have been a misguided effort to appease Chinese debt holders.

Further, as the debate regarding the fate of the two private companies, Fannie and Freddie, is a political one, we should consider which political party would benefit most by doing away with the 30 year home loan/mortgage. Both sides perhaps point to the other. Is it possible to put politics aside? If we help more individuals build financial security and perhaps wealth, we increase the tax base. And, isn’t that what we’ve been told the Conservatorship was meant to do — “protect American taxpayers?”

Perhaps the sealed documents in Judge Sweeney’s court further expose this confusion, miscalculation and the vulnerability the US has to foreign debt holders.

“The Group of Thirty, established in 1978, is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia. It aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers.”

“Governments throughout the world contributed in a variety of ways to the expansion of leverage. As we have seen, central banks played a significant role through their control of interest rates (at least at the short end of the yield curve). However, governments contributed to the crisis at the legislative, executive, and regulatory levels, as well. By holding interest rates at abnormally low levels during the extended period between 2000 and 2008, central banks encouraged the massive glut in worldwide liquidity and the corresponding asset price inflation that characterized those years. Moreover, in addition to providing liquidity by keeping interest rates low, central banks and other bank regulators allowed higher levels of effective leverage to arise throughout the financial system by granting unwarranted credit to risky assets on bank balance sheets. Thus, for example, banks were encouraged to purchase highly rated tranches of subprime mortgage-backed securities because they were granted favorable capital treatment under Basel II and related bank regulatory regimes. Through their roles in increasing liquidity and encouraging it to be directed to risky real estate assets, central banks and bank regulators cannot escape their share of blame for the crisis—as noted by John Taylor, who observes that the “New York Fed had the power to stop Citigroup’s questionable lending and trading decisions and, with hundreds of regulators on the premises of such large banks, should have had the information to do so. The…SEC…could have insisted on reasonable liquidity rules to prevent investment banks from relying so much on short-term borrowing through repurchase agreements to fund long-term investments.”

Taylor’s view is echoed by the Financial Crisis Inquiry Commission, which observed that among U.S. regulators “there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not.”

The legislative branch also bears some level of responsibility for the crisis, at least in the United States. This responsibility derives in significant part from various forms of congressional support provided to Fannie Mae and Freddie Mac since their formation in the post-World War II era, which distorted mortgage interest rates, thereby increasing leverage throughout the economy by facilitating increased lending to homebuyers, and allowed the Government Sponsored Enterprises (GSEs) to conduct business at an inadequate level of capitalization that would not have been possible without their implicit government guarantee.

This begs the question, however, of why the government promoted increased lending to consumers, especially to groups that did not have extensive previous experience with homeownership or debt management. Some commentators believe that government promoted residential real estate lending as a way that both major political parties could accept to increase the middle class’s perception of wealth during an extended period of stagnant wage growth. As noted by the former chief economist of the IMF, “We have long understood that it is not income that matters, but consumption. A smart or cynical politician knows that if somehow the consumption of middle-class householders keeps up, if they can afford a new car every few years and the occasional exotic holiday, perhaps they will pay less attention to their stagnant monthly paychecks. Therefore, the political response to rising inequality—whether carefully planned or the path of least resistance—was to expand lending to households, especially low income ones.”

In addition, Congress’s decision to exempt over-the-counter derivatives from regulation allowed for the rapid growth of a product that played a critical role in the crisis by magnifying the risks presented by mortgage-backed securities, while increasing the interconnectedness of financial institutions and decreasing transparency. As noted by the Financial Crisis Inquiry Commission, the “enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis.… [W]ithout any oversight, OTC derivatives rapidly spiraled out of control and out of sight, growing to $673 trillion in notional amount.… They amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and spread them throughout the financial system.… [T]he existence of millions of derivative contracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to the uncertainty and escalated panic, helping to precipitate government assistance to those institutions.”

In the United States, these efforts took both the form of providing capital support to significant financial institutions whose failure was seen as severely disruptive of global liquidity, and programs designed to encourage the revival of markets for specific types of liquidity. Examples of the former include the support provided in the cases of the nationalizations of Fannie Mae and Freddie Mac, the TARP bailouts of AIG, Bank of America / Merrill Lynch, Citibank, and others, and the implicit support provided to Goldman Sachs and Morgan Stanley through the government’s accelerated conversion of those entities to bank holding companies. To get a true perspective on the problems presented by government indebtedness, one must also consider the off-balance-sheet obligations of the U.S. government, which are in the neighborhood of $132.8 trillion on a gross basis (or approximately $66.3 trillion, net of related allocated revenues such as Medicare and Social Security taxes and revenues associated with the assets of Fannie Mae and Freddie Mac).

Even assuming the federal government has the willpower to undertake the mammoth task of reforming entitlements, attention has only recently begun to focus on another significant elephant in the room: how to address Fannie Mae, Freddie Mac, and the federal government’s role in housing finance. As noted by the Wall Street Journal, the “biggest single bill to taxpayers [from the 2008 crisis] will come not from a bank bailout, but from mortgage giants Fannie Mae and Freddie Mac.” Unlike other financial institutions rescued by the federal government’s support, which in many cases “have paid back taxpayers with interest[,] Fannie and Freddie…burdened by huge mortgage portfolios, have taken $145 billion so far.… Alan Blinder of Princeton University and Mark Zandi of Moody’s Analytics put the ultimate price for saving them at $305 billion.”

The cost of the rescue of Fannie and Freddie, however, is not reflected in the federal government’s budget. As a result, the already staggeringly large official budget deficit is significantly higher when the government’s support for Fannie and Freddie is included: “The Congressional Budget Office estimates that if the entities had been included in the 2009 federal budget, they would have added $291 bn to the deficit, pushing it up by 20 percent.”

Moreover, in addition to the costs associated with the Fannie / Freddie bailout, there remains the vexing challenge of how to address the government’s role in private U.S. residential mortgage finance. Even prior to the bailout, the prime mortgage financing market depended on the critical role played by Fannie and Freddie purchases and securitization of prime mortgage loans, which was in turn supported by the federal government’s implicit guarantee and its consent to the GSEs’ enormous leverage ratios of nearly 70 to 1. As with other overleveraged financial institutions, in 2008 the GSEs lost liquidity and faced insolvency as asset prices dropped. Unlike other financial institutions rescued by the U.S. government, which in most cases have stabilized since 2008 and have been able to begin to repay government support, the GSEs in 2008 played (and continue to play) an integral and preeminent role in U.S. housing finance. Because a collapse of Fannie and Freddie in 2008 would have threatened the entire system of U.S. housing finance with collapse, the federal government “nationalized the mortgage market and hasn’t found a way out. So taxpayers keep pumping money into Fannie and Freddie at a rate of greater than $1 billion a week.”

As a result of the GSEs’ continued centrality to the U.S. residential real estate market, the Wall Street Journal has correctly observed that the “mortgage-finance debate will be highly contentious because it requires a re-examination of just how much the U.S. government should subsidize homeownership.” Confronting this issue will force the government to consider politically charged questions such as which socioeconomic segments of the population should be able to purchase homes and what form of mortgage finance best promotes the stability of the U.S. (and international) financial system and the U.S. economy. It will entail confronting hard truths, such as the observation bluntly made by PIMCO’s Bill Gross that “‘America has been overhoused.’” Fundamentally, as noted by the Wall Street Journal, “At the heart of the debate is whether the U.S. should continue to promote a low-cost, 30 year, fixed rate mortgage, which often requires some type of government guarantee to make investors willing to buy mortgage-backed securities.”

Although 30-year fixed-rate residential mortgages have been the conventional means of housing finance in the United States for almost 80 years, this was not always the case, and does not hold true in all countries outside the United States. As reported by the Financial Times, “in the 1930s, the average [U.S.] home loan was of short duration, typically three to five years; required a large deposit; and carried high interest rates, putting it out of reach of most.” While the GSEs are today widely criticized for contributing to the debt-fuelled housing bubble that led to the 2008 financial crisis, it is also worth remembering that, in the 1930s, it was “government agencies [that] developed long-term loans, later followed by fixed rates, lending stability to the market and making mortgages more widely available.”

The widespread availability of the 30-year fixed-rate mortgage has contributed in part to U.S. homeownership levels of approximately 67 percent today, higher than the wealthy industrial country average of approximately 60 percent and a significant increase over the approximately 45 percent homeownership rate prior to Fannie’s formation in 1938. While other factors also contributed to this increase, in part it occurred because the 30-year fixed rate mortgage provides undeniably useful benefits to homeowners, such as making monthly payments more affordable and offering protection against interest rate shifts. However, those very benefits make it a troublesome private investment. Indeed, the possibility of borrower prepayment and insulation against increases in inflation and interest rates over a long period of time make it difficult to imagine a vibrant private market in conventional residential mortgages arising without some level of government support.

For example, at the recent GSE summit PIMCO’s Bill Gross asserted that “loan rates would be ‘hundreds of basis points higher, creating a moribund housing market for years’ without government-guaranteed bonds, and that he wouldn’t buy securities without such backing unless they contained loans with 30 percent down payments.” Thus, while the Obama administration has called for a “process of weaning the markets away from government programs[to] make room for the private sector to get back into the business of providing mortgages,” Treasury Secretary Geithner’s remarks at an August 2010 conference on the GSEs “offered the clearest indication yet that the administration’s working plans to reinvent mortgage giants Fannie Mae and Freddie Mac—and the entire mortgage-finance system—will almost certainly include some role for government.”

In addition to the difficulties in addressing the government’s role in the housing market the enormous capital shortfall of the GSEs significantly complicates efforts to find a solution. As observed by the Financial Times, “if the GSEs are privatised, they will be forced to recapitalise.…

Given that the GSEs have a combined balance sheet of $5,000 bn, they would need to raise some $250 bn” to have capital levels comparable to private lenders, which under Dodd-Frank will be required to have “skin in the game” of 5 percent retained credit risk with respect to mortgages they securitize. Although the Obama Administration in August 2010 convened a multidisciplinary summit on the issue, and has indicated that it will present a detailed proposal to address the GSEs, there is no easy solution to the government’s ownership of Fannie and Freddie, or the more fundamental question of their (and the government’s) role in U.S. housing finance. As noted by the Wall Street Journal, “Fannie and Freddie,…together with the Federal Housing Administration are backstopping nine out of every 10 new [residential mortgage] loans.”

The difficulty in extracting the U.S. government from such a dominant role in residential mortgage finance is compounded by the enormous amount of outstanding GSE debt, which is widely held by institutions and foreign governments. This complication was highlighted in comments in August 2010 by PIMCO executive Bill Gross, “whose firm is among the biggest holders of U.S.-backed mortgage debt[, that]…the U.S. should consider ‘full nationalization’ of the mortgage-finance system.” While PIMCO’s position “is at odds with industry and government officials who have urged a smaller federal role, it reflects the difficult nature of the government’s ultimate decision: whether to pursue a more fundamental reform of the housing market that would adversely affect existing bondholders. Given this tension, and the size and importance of the GSE bond markets, although “administration officials have said the previous ownership model for Fannie and Freddie should be discarded[, and have thus]…promised to deliver ‘fundamental change,’ officials are likely to proceed slowly—focusing as much attention on any transition as they do on the final destination—to avoid rattling the $5 trillion bond market for government-backed mortgages.”

Moreover, the size of the GSE bond market and the identities of its largest investors mean that the implications of addressing Fannie and Freddie are not simply limited to its effect on U.S. housing finance. Rather, as noted by the Financial Times “a mishandling of the problem would have implications not just for U.S. homeowners, who could face scarcer financing, but also investors the world over, including the Chinese, Japanese and other governments and central banks[, because f]oreign investors own about one-third of Fannie’s and Freddie’s noncallable notes.” In fact, some market observers believe this dynamic explains the unconventional 2008 “conservatorship” of Fannie and Freddie, in which existing creditors were made whole regardless of the GSEs’ insolvency: “The political importance of these institutions created a new world, one in which a bond’s performance is determined by the reputation of its holders.… Russia and China were among the largest holders of Fannie and Freddie bonds [in 2008.] Recall in 2008 that Russian tanks were rolling into Georgia, while the U.S. was utterly dependent on China to purchase its debt. So, unusually, the identity of the holders, not the condition of the issuer, determined the bond’s fate.”

The concept that powerful bondholders can have a greater influence on the result of a restructuring than the issuer’s financial condition has important implications for sovereign issuers struggling with their debts. As noted by the Financial Times, “the same pattern was seen in Greece, where a rescue came because the debt holders were vulnerable European banks. More typical sovereign debt restructures, as seen in Brazil and Mexico in the 1980s, followed different rules.” Because any resolution of Fannie and Freddie will need to address not only the fundamental question of how housing in the United States is financed, but also account for the risks any reform will present to such an enormous, critical market, it is difficult to see how government will find the resolve to address them in a way that allows the United States to limit its role in housing finance while reducing the likelihood of future real estate bubbles. Resolving the issues presented by Fannie and Freddie takes on additional urgency when considered in light of the potential future strain on the federal budget resulting from the needs of state and local governments and the significant increase in entitlement spending expected from the impending retirement of the baby boomers. Continued funding of the GSEs has the potential to divert federal resources from these other critical priorities amid growing concern over mounting deficits. Given the slow economic recovery, the limited resources the federal government has to respond to a potential municipal crisis, and the need to address growing entitlement demands and the significant amount of federal, state, and local debt, a multifaceted approach is required that includes a combination of short-term, medium-term, and long-term initiatives.

As this paper has shown, the challenges facing the U.S. economy are difficult and interrelated, and addressing them will result in uncomfortable sacrifices across U.S. society. Because interest groups will lobby to promote their narrow, short-term interests and legislators focused on the next election will be vulnerable to a cherry-picking approach, the traditional legislative approach cannot successfully address the country’s long-term problems.”